Income Approach

The income approach is the appraisal method that values property by the income it produces. Its simplest form, direct capitalization, divides a single year's net operating income by a cap rate. Its fuller form, discounted cash flow, projects income over a holding period and discounts it back.

Direct capitalization is where the cap rate comes from. Value equals NOI divided by cap rate, and the cap rate is derived from comparable sales, from the band of investment (weighting the mortgage constant and the equity return by loan-to-value), or from a discount rate minus expected growth.

That last derivation explains why cap rates fall in growth markets: a buyer who expects NOI to rise accepts a lower yield today. It also explains why cap rates carry a risk premium above safe interest rates. Appraisers use the income approach as the primary method for commercial property and as a supporting method for two to four unit rentals, where comparable sales usually lead.

Further reading: Income Approach on Wikipedia.